Anatomy of dollar cotton

Over the last few years annual world cotton production deficits of between 2 million and 3.7 million bales have slowly but surely been whittling down burdensome world stocks. In 2009-10, however, the production deficit blew up to 16.4 million bales due to production shortfalls in major cotton-producing countries.
The behavior of the Chinese government only adds to the bullish theme.
Another bullish factor for higher cotton prices is the value of the dollar. But the dark side of this fundamental is increasing U.S. federal debt,
Another contributor to the perfect storm in cotton is the technical uptrend of the market.

Dollar cotton in 2010 is riding the convergence of several bullish factors including a massive world production deficit in old crop cotton, the declining value of the dollar, strong technical signals and growing demand, according to Peter Egli, risk manager, Plexus Cotton, speaking at the Ag Market Network’s Oct. 12 teleconference.

Egli noted that over the last few years annual world cotton production deficits of between 2 million and 3.7 million bales have slowly but surely been whittling down burdensome world stocks. In 2009-10, however, the production deficit blew up to 16.4 million bales due to production shortfalls in major cotton-producing countries.

The deficit “is by far the biggest on record,” Egli said. “The jury is still out in regard to the current season. But at the moment, USDA projects another seasonal deficit of around 4.1 million bales.”

The behavior of the Chinese government only adds to the bullish theme, according to Egli. “There has been a massive effort to auction off reserve stocks to keep local markets supplied with cotton. Since May 2009, the Chinese government has auctioned off about 15.2 million bales of its reserve, a figure which does not include a recent allocation of about 1.3 million bales.”

So far, USDA statistics have not completely reflected this significant drawdown, noted Egli. Part of the reason could stem from USDA’s announcement in May 2005 that it would begin to systematically add residual to the Chinese supplies to offset a tendency to underestimate Chinese production.

Make little sense

The adjustments, which added 10.75 million bales to Chinese supplies, “might have been justified three years ago, but they make little sense to me when there is obviously large-scale restocking going on in China,” Egli said. “Instead of 18.2 million bales back on Aug. 1, China probably had no more than 12 million to 13 million bales. This is why the Chinese market has been behaving like it’s been running out of stocks. It literally is running out of stocks.”

Egli also believes global beginning stocks should probably have been a lot lower for 2009-10. “Instead of 47 million bales, we may actually have had no more than 40 million to 42 million bales to begin the season, which changes the stocks-to-use ratio dramatically from 39 percent to almost 35 percent. At the end of this season, we may end up with less than 40 million bales unless we see demand destruction over the coming months.

“As mills began to realize the stocks they needed to tide them over into new crop were limited, they started to mop up all available supplies they could find. Then we had the flood in Pakistan and the threat of an export ban in India which added more fuel to an already panicky market. As a result, we had cash prices explode by over 35 cents since the end of July.”

Egli said that Chinese cotton prices are already trading at $1.60.

According to Egli, high prices of 2010 are unlike the high prices of March 2008, “when a liquidity squeeze in the futures market pushed prices higher, while the cash market never followed through. This time, the cash is leading the way and the futures market has been playing catch up. It is an extremely bullish sign.”

Another bullish factor

Another bullish factor for higher cotton prices is the value of the dollar, according to Egli. But the dark side of this fundamental is increasing U.S. federal debt, which around $13.5 trillion and growing about 2 trillion per year, “which is simply unsustainable. Economic growth is too weak to be the solution at the moment. It takes $9 of new credit to get one dollar of gross domestic product, which is more than twice as much as it was 10 years ago.”

The Federal Reserve’s response is to print more money, Egli noted. “Think of it this way. It there is an ever-increasing amount of paper money chasing a relatively finite amount of goods, then the value of commodities measured in paper money has to go up.”

On the other hand, if the value of cotton is measured against the ultimate hard currency — gold, its value has decreased, Egli says. “In 2003, a bale of cotton was worth about 1 ounce of gold. In March 2008, a bale of cotton could be purchased for a half an ounce of gold. Today, it takes only about one-fourth of an ounce of gold to pay for a bale of cotton.”

Egli says that as “investors are seeing that the printing press is not the solution to an economic problem, we are seeing diversification into tangible assets like commodities in an effort to preserve value and there is no end to the trend in sight.”

Another contributor to the perfect storm in cotton is the technical uptrend of the market, according to Egli. “It has attracted technical and computer-based spec buying into the market, and they will stay with this trend as long as it lasts.”

Egli believes the cotton market will settle into a trading range of between 90 cents and $1.10 “once the current panic blows over.” He also believes that prices should remain high, especially with the devaluation of the U.S. dollar “which will continue to force the price of just about everything higher over time.”

Another factor is that in a few years’ time, “daily demand for crude oil will bump against the world’s ability to produce it, which means that energy prices are going to rise further. This will have a bullish impact on cotton prices.

“While cotton consumption may react negatively to these high prices for a short time, bear in mind, cotton consumption in absolute terms will continue to go higher, even it loses the race against man-made fibers.”

The potential is huge, according to Egli. “If global per capita consumption of cotton was to rise to the level of U.S. per capita consumption, annual cotton demand would be around 460 million bales. I’m sure the same holds true for other ag products. It will become increasingly more difficult to meet all the demand out there.”